Up-to-the-minute advice, information, resources, and, on occasion, commentary on federal and New Jersey state income taxes, and the various New Jersey property tax rebate programs, and insights and observations on tax policy and professional tax practice, by 40-year veteran tax professional Robert D Flach.

Wednesday, July 11, 2007

THE K-1 BLUES

The Form K-1 for a limited partnership investment is the scourge of the tax preparer!

Over the years I have had many clients who, in addition to shares of stock or mutual funds, also owned “units” of a limited partnership venture. If you own stock or mutual funds you report on your Form 1040 any dividends received. While investors in a limited partnership may receive distributions similar to dividends, they do not report what they have received from the partnership but instead their “distributive share” of the entity’s individual sources of income, losses, deductions and credits. A limited partner receives a Form K-1 to report his/her distributive share of the income, losses, deductions and credits.

The first problem with K-1s from the point of view of a tax preparer is that they always arrive late. Unlike other tax information reporting forms, like 1099s and 1098s which are required to be sent to taxpayers by January 31st, investors do not receive their Form K-1s until the middle or end of March. Some do not come until April. The due date of the federal partnership tax return, Form 1065, is generally the same as the due date for the Form 1040. Because I do not want to work on 1040s in “installments” I cannot begin the tax return of a client with limited partnership investments until late in the season, when I am usually already backed up.

The second problem is that because limited partnerships invest in real estate, oil and gas, timber, commodities and futures, and the like they often generate unique deductions and credits that must be reported on any number of obscure supplemental tax forms and schedules. Each form and schedule takes time to complete. In most cases it seems to me that I am spending an hour or more to complete all the required supplemental forms and schedules to provide the client with a minimum effective tax savings. It costs more to prepare the multitude of forms and schedules than any ultimate tax benefits provided!

The third is that because of the nature of limited partnership investments you cannot simply take the individual items of income, deduction and credit reported on the many lines of the Form K-1 and directly transfer them to the 1040 as is – not that that is a simple process. Limited partnerships fall under the rules of a “passive investment” and as a result are limited in the amount of losses, deductions or credits that can be claimed.

An investor in a limited partnership is a “limited” partner. A “general partner” manages the business and is personally liable for the debts of the partnership. A “limited partner” is liable only to the extent of his/her dollar investment in the partnership. If a person invests $1,000.00 as a limited partner the most he can lose is the $1,000.00. The deduction of losses from a limited partnership is first limited to the investor’s “at risk” basis. Generally a limited partner with an investment of $1,000.00 can only deduct up to $1,000.00 in losses from the entity.

Limited partnership losses are also subject to the passive loss limitation rules. As a general rule passive losses are only deductible to the extent of passive income. In the acronyms of the tax world, a PAL (passive activity loss) needs a PIG (passive income generator). Losses that cannot be deducted on the current year Form 1040 are “suspended” until the investment is disposed of (you sell your units or the partnership terminates) or passive income is generated. And who do you think is going to be the one to keep track of all these suspended losses – certainly not the client!

Generally losses from one limited partnership can be deducted against income from another limited partnership. However, there is a special type of limited partnership called a Publicly Traded Partnership (PTP). You can offset losses from a PTP only against income or gain from the same PTP. You cannot apply losses from a PTP against excess gain from another limited partnership. Income and losses from a PTP are not reported on Form 8582 (Passive Activity Loss Limitations). Any net income from current year activity less prior year unallowed losses is reported as “nonpassive income” directly on Schedule E. So PTPs require even more detailed recordkeeping.

Why do individuals invest in limited partnerships? I doubt any of my clients that have owned a limited partnership investment over the years actually called up his/her broker and said, “I want to buy some units of XYZ Timber LP.” Individuals invest in limited partnerships because their brokers tell them to!

While I cannot say this with certainty, it is my belief that brokers receive a higher commission from selling limited partnership units than from selling traditional shares of stock. Similar to the fact that a broker will receive a higher commission from selling an annuity. In many cases the brokerage house will “encourage” their brokers to push a certain limited partnership in which the house has some kind of vested interest. I remember years ago when almost all my clients with accounts at Shearson (a name that has disappeared due to multiple subsequent mergers) owned a Balcor limited partnership.

As I do not own any limited partnership units myself (the only time I was tempted was when I received an offering from Broadway produced Alexander Cohen to invest in a Peter Cooke and Dudley Moore review back in the 1970s – instead I invested in my own local production of Stephen Sondheim’s COMPANY which did not show a profit, unlike the Cooke and Moore show) and I do not follow the market, I cannot say whether a limited partnership investment has the potential to return a greater profit than a stock or bond investment. I do know that several limited partnerships offer the pas through to investors of specialized tax credits – although often these credits must eventually be “recaptured”, which causes more tax preparation nightmares.

As a point of information - for a great while the IRS was not able to properly match K-1 information to 1040s, as it has been able to do with 1099 information returns for just about all of my years in “the business”. However that appears to no longer be true. Already this year I have seen IRS notices regarding income from 2006 K-1s not reported on the corresponding Form 1040.

I would certainly welcome hearing from brokers on the merits of investing in a limited partnership, and would also be interested in knowing if brokers do indeed receive a greater commission or incentive to sell such investments (you can make your comments anonymously). I want to know if the necessary additional tax preparation fees charged to clients for all the extra work and agita that comes with limited partnership Form K-1s is worth it. I also welcome comments from taxpayers who have invested in a limited partnership and from fellow tax preparers.

7 comments:

Anonymous
said...

Don't know about the brokerage industry, but private bank investment clients are introduced to partnerships as a wrapper for alternative investment vehicles that provide diversification for a stock/bond/cash portfolio by virtue of the undelying investment's low correlation to markets. Fees are no different in my world and we are not compensated based on product sales. The diversification can provide significant risk reduction to a portfolio.

That being said, many of our professional (atty,MD) clients come to us with existing L/P's of the old tax shelter variety - - most don't remember why they bought them.

I "inherited" 4 of these. What a nightmare for the taxpayer as well! 2 have recently sold and I get to pay all of the taxes! Ex. $15,000.00 investment in the 80s equals $80,000 today with a tax liabiilty of $15,500 even though I only netted $3,000 from sale! How can I get rid of the last two w/o tax consequence other than roll over? I wish I had been disinherited!

(1) If you truly inherited the limited partnership investments as beneficiary your “cost basis” should be the fair market value of the investments on the date of death of the original owner – and not the $15,000 that it originally cost the deceased. You should check with the Executor to find out the value of these investments on the federal estate (if required) or state inheritance tax return.

(2) You cannot “rollover” a limited partnership investment. You can only rollover an IRA or pension distribution.

Thank you for response and advice re: "inherited" partnerships. I hope to be filing an amendment after I find a new accountant! re: "rollover" was bad choice of words, I should have said "exchange" as I believe there is something called a 1031 account that is used for flipping houses to avoid paying capital gains taxes. Would you recommend this?

You are right about the difficulty posed by K1s, but the bigger issue is you get hammered when you sell them. Why? Because every year the box 1 ordinary business loss serves to reduce your basis cost in the LP, if it is a PTP. So when you sell, you get a huge capital gain!!!

I disposed of a Limited Partnership associated with a golf course on Dec. 31, 2011, the last day of the year. I received my K-1 but it does not indicate it is the "Final" K-1. Isn't a "Final" K-1 required if I disposedof it?

I see this topic was last commented on some time ago, but I too have been frustrated by the number of these PTPs for oil and gas that our local financial advisors have gotten my clients into. I don't think the clients have any idea what I go through keeping tract of the suspended losses and refreshing my memory every time I pick one of these K-1s up. My clients that have these are generally retirees, and they don't even bring me all the K-1s when they receive them. I have created IDs on the web sites of these PTPs so I can access the K-1s myself!

I contacted the financial planner that is pushing these and suggested that he stop putting one of my clients (the forgetful one) in these investments, because if I retire from tax preparation, I think my client will be shocked at the cost of having his taxes done. I have never charged him more than $180 to prepare his return, even though some years I have had over 20 hours into it. When I spoke with the planner,he was FURIOUS that I would suggest that someone should stop using such a great investment just for the "convenience" of easier tax preparation.

Further, the client has $50k of carryover losses from this same planner's investments, plus the suspended losses from the PTPs. He is 75 years old, and probably will not live long enough to use up his losses, which will be lost when he dies.

The only person I see benefitting from all this is the financial planner.

Before contacting me with questions about how a blog post relates to your specific situation, please be aware that I do not give free tax advice to non-clients by e-mail, comment response, or phone. So don't waste your time and mine.